Abstract

https://ssrn.com/abstract=2706590
 


 



Predicting Self-Fulfilling Financial Crises


Christopher Gandrud


City University London - International Political Economy; Hertie School of Governance

Thomas B. Pepinsky


Cornell University - Department of Government

December 21, 2015


Abstract:     
This paper studies how self-fulfilling dynamics affect the predictability of financial crises. We build a model in which market participants play an investment coordination game with common economic shocks and private information about their own willingness to cooperate. An observer attempts to predict the occurrence of a financial crisis in the future based on the players’ actions in the present. Under favorable conditions, good market conditions prevent an observer from learning about players’ types by observing their actions. This induces a negative correlation between economic conditions in the present and the variance of players’ types in the following period, which defines the predictability of financial crises. Under more extreme positive market conditions, the observer cannot use present observations of the players to learn about the probability of a financial crisis in the future. We test the implications of the model using a new continuous measure of financial market stress – “FinStress” – developed by Gandrud and Hallerberg (2015). We find support for a key implication of our theory: the variance of financial market stress is larger following periods of good economic conditions than following poor economic conditions. These conclusions have implications for both empirical analyses of the predictors of financial crises and for policymakers seeking to prevent crises. The findings in our paper suggest that regulators should focus on actors’ types (e.g. with stress tests) more than macro-economic conditions. More broadly, our analysis provides a new explanation for why social scientists and area specialists are generally poor at predicting events that require mass coordination, such as financial crises, coups, and revolutions.

Number of Pages in PDF File: 40


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Date posted: December 22, 2015  

Suggested Citation

Gandrud, Christopher and Pepinsky, Thomas B., Predicting Self-Fulfilling Financial Crises (December 21, 2015). Available at SSRN: https://ssrn.com/abstract=2706590 or http://dx.doi.org/10.2139/ssrn.2706590

Contact Information

Christopher Gandrud (Contact Author)
City University London - International Political Economy ( email )
Northampton Square
London, EC1V 0HB
United Kingdom
Hertie School of Governance ( email )
Schlossplatz 1
Berlin, 10178
Germany
Thomas B. Pepinsky
Cornell University - Department of Government ( email )
Ithaca, NY 14853
United States
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